IFM9 Ch 18 Instructors Manual

Chapter 18Initial Public Offerings, Investment Banking, and Financial

RestructuringANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS

18-1 Reasons for going public include the following. Note that, generally, several of these reasons will be important at the time of the IPO.

To raise additional capital. Original investors may be tapped out, or they may not want to put additional funds into the business for diversification reasons. Thus, the company needs to bring in outside funds, and an IPO is the most efficient way of doing so.

Founding stockholders want liquidity, which a public market would provide. Founding stockholders want to diversify. They can sell some shares during or after

an IPO. Many companies use stock options as part of their compensation plans. Employees

with options, like founding stockholders, want liquidity and the opportunity to diversify their holdings.

To establish a market price, which is useful for incentive employee option programs, for mergers, for estate tax purposes, and in divorce situations.

Public ownership may help the company make sales, because public ownership may provide credibility with regard to “staying power”—no one wants to be dependent on a supplier that goes under because it was unable to raise needed capital. Also, public ownership may provide some beneficial advertising effects.

Some downsides to public ownership include: Costs, disclosure requirements, harder to engage in self-dealings that benefit the controlling stockholders.

Also, analysts do not follow very small stocks where trading volume is necessarily small. Therefore, if a firm is so small that an active market for its stock cannot be developed, then public ownership won’t really make it liquid, and the price will fluctuate widely and not necessarily reflect the firm’s true value.

In addition, if the firm goes public, it might be easier for a raider to gain control and oust the managers. This is something that managers consider, especially if the management team will not have over 50% of the stock after the public offering.

Finally, it is interesting to note that some very large companies with tens of thousands of employees like Publix, CM2Hill, and Cargill have been able to get most of the advantages listed above without actually going public. These companies have developed internal markets that work as follows: (1) The company hires an investment banking firm to operate the plan, which is set up much like a mutual fund, with each participating employee having an account. (2) The banker develops a formula for pricing the stock,

Answers and Solutions: 18 - 1

taking account of book value and earnings per share, the state of the stock market as measured by an index of comparable companies’ stock plus an index such as the S&P 500, the level of interest rates, and so forth. The formula will be adjusted over time to ensure that there is a fairly good balance between buyers and sellers. (3) Several times a year, employees will be given the opportunity to buy or sell shares at the announced formula price. If more buy orders than sell orders come in, the company may create and sell new shares. If sell orders exceed buy orders, the company will buy the excess and thus offset the imbalance. The company can also offer new shares to its employees if it wants to raise additional equity capital, or it can repurchase shares if it wants to reduce equity. If the company is large enough, such an internal market will provide liquidity and also serve most of the other functions of a public market, with the additional advantage that all of its stockholders will be in a position (as employees) to help the company perform well operationally.

18-2 In the late 1990s it was common for IPO stocks to rise far above the offering price on the first day of trading. This situation indicated that companies were “leaving money on the table,” i.e., that they could have gotten more for the shares they sold than they actually received. This under-pricing was rationalized on several grounds, including (1) that it reduced risk to the underwriter and thus lowered costs to the issuer, (2) that it helped enhance the reputation of the underwriter, which benefited the issuer, and (3) that it helped insure a successful offering and thus made follow-on offerings easier to complete. In addition, if the issuing firm sold only a small percentage of its shares, the under-pricing did not cause too much of a problem on a percentage basis.

Note too that today it is clear that the analysts who worked for some investment bankers rated some stocks higher than the fundamentals would justify, making the offering price closer to the underlying value than appeared from the post-issue run-up. Also, and very importantly, under-pricing enabled investment bankers to reward their good customers and give what amounted to bribes to executives of companies that were potential underwriting clients. Several investment banking firms have been sued in connection with this practice.

The situation changed after 2000, when stocks, and especially the kinds of Nasdaq stocks that had been leading the IPO market, crashed. Then, it became difficult for a company to have an IPO, and the few that came out rarely had big run-ups and often actually declined. See text Table 17-2 for data on this issue, and note that the corresponding table in the last edition of the text (two years earlier) showed far higher run-ups.

The subsequent crash in stock prices suggests that the valuations put on many IPOs, and on tech stocks in general, was also too high, which could be another sign of an inefficient market. That would not necessarily relate to inefficiency in the IPO market per se, but in the late 1990s the IPO market and the general stock market, especially the Nasdaq market, were closely related.

All of this does suggest that the IPO market was not very efficient, at least in the late 1990s, in the sense of giving the seller the highest price buyers were willing to pay. The SEC and the NASD are currently (March 2005) investigating the IPO market, and the end result may be a more efficient IPO market in the future.


Example of IPO PricingAn example of how an IPO would be priced is shown in the BOC model. The

valuation is, of course, a critical issue. Theoretically, the proper pricing basis is the DCF model as discussed in Chapters 5 and 11. Data on publicly-owned companies that are comparable to the company that is going public would be obtained and used to develop a discount rate, which would then applied to the company’s projected cash flows. Although the DCF model should be given the most weight in the valuation, investment bankers also look at selected multiples, especially the P/E and M/B ratios. For example, if a set of comparable companies has an average P/E of 20 and an average M/B of 3.0, and if the company in question has total earnings of $10 million and total book equity of $70 million, then it’s valuation would be $10,000,000(20) = $200 million by the P/E multiple method and $70,000,000(3.0) = $210 million by the M/B multiple method. Then, if the DCF analysis had also produced a valuation of about $205 million, the final corporate valuation would be set at $205 million. Of course, the three methods would rarely if ever produce exactly the same results, so in practice the final valuation would be some sort of judgmentally determined weighted average of the three separate valuations.

Given the total valuation, the bankers would need to find a price per share. Bankers generally like to offer new stock at about $15 per share, though a higher price may be used for IPOs of large, established companies like Kraft, which came out at $31 per share. Assuming the target price is $15, then the company will divide the total value by $15 to determine the total number of shares, so in our example the company should have $205,000,000 / $15 = 13,666,667 shares outstanding when it goes public. If the actual number of shares currently outstanding is different from this target, then a split or reverse split would be used to get to the target number.

IPOs can consist entirely of currently outstanding shares to be sold by current stockholders, or entirely of new shares sold by the company to raise new capital, or a combination of the two.

Suppose the company wants to raise $10 million of new money to fund its business plan. If it needs 10 million but flotation costs would amount to 7%, then it will have to raise a gross amount of $10 million / (1.0 – 0.07) = $10,752,688. In that case, it would issue $10,752,688 / $15 = 716,846 shares.

18-3 A rights offering is when a company sells shares and offers those shares to its current shareholders on a pro rata basis. Each shareholder is given an option called a “right” to buy a stated number of shares at a specified price within a stated period. The stockholder can exercise the right and buy new shares or sell the right to some other party who wants to buy the new shares. Typically, companies use rights offerings in order to allow existing stockholders to maintain their relative position in the company, if they so desire. Most private companies have the preemptive right, but most public companies do not, because stockholders can increase or decrease their holding in public companies easily.

An example of a rights offering is provided in the Excel model. It illustrates how rights are valued. It also shows that the lower the exercise price, the greater the “stock split effect,” and it shows that stockholders will come out with the same wealth regardless of whether they sell their rights or exercise them.


18-4 An original issue discount (OID) bond is a bond that, when issued, provides a coupon

rate that is below the current market interest rate, i.e., rcoupon < rd. Since the coupon rate is low, the bond will sell at a discount, but the discount must be such that the expected return on the bond is equal to rd. Of course, many bonds, when they are sold, have rcoupon

= rd , but rising rates in the marketplace cause the bond to sell at a discount. Those bonds are not original issue discount bonds—they are just plain bonds that sell at a discount due to changing market conditions.

One important class of OID bonds is the zero coupon bond, which pays no interest, sells at a substantial discount, and they pays off at face value when it matures.

The value of zeros and other discount bond tends to rise over time, and their value must be close to their face value ($1,000) just before maturity unless they are likely to default. The projected annual increase in value is called “accretion,” and for an original issue discount bond, it is treated for tax purposes as ordinary income, not capital gains. If a bond is issued at par and then falls to a discount due to interest rate changes, then someone who purchases this discount bond can earn a capital gain if interest rates later fall and the bond rises in value.

OID bonds are typically callable at the accreted value plus a specified call premium, such as 2% over the accreted value.

An example that shows how zeros are evaluated, and how returns on such bonds are calculated, is provided in the Excel model.

18-5 The bond refunding decision is, in essence, a capital budgeting decision. A bond will be called if interest rates decline after the bond was issued by an amount sufficient to cause the annual interest saving from getting rid of the old-high interest bond and replacing it with a new low-interest bond to offset the costs associated with the refunding, mainly a call premium and flotation costs for the new issue. If the PV of the interest savings is greater than the costs associated with the refunding, then the refunding will be profitable. Taxes must be taken into account, and the flotation costs associated with the new and old issues must be dealt with properly. An example of refunding analysis is provided in the Excel model.

Even though the NPV found in a refunding analysis is positive, it might be better to wait rather than call the bond immediately. If interest rates continue to decline, the NPV of the refunding might be much greater if the company delays the call. The ability to call the bond is an option that the issuing company holds, and when they issue the call, they are exercising the option. Like any option, it may or may not be advantageous to exercise it when it first gets “in the money.” So, a critical element in the refunding analysis is a projection of future interest rates, and if rates are likely to decline in the future it may be best to delay the call. Again, this is illustrated in the model.


ANSWERS TO END-OF-CHAPTER QUESTIONS

18-1 a. A closely held corporation goes public when it sells stock to the general public. Going public increases the liquidity of the stock, establishes a market value, facilitates raising new equity, and allows the original owners to diversify. However, going public increases business costs, requires disclosure of operating data, and reduces the control of the original owners. The new issue market is the market for stock of companies that go public, and the issue is called an initial public offering (IPO).

b. A public offering is an offer of new common stock to the general public; in other words, an offer in which the existing shareholders are not given any preemptive right to purchase the new shares. A private placement is the sale of stock to only one or a few investors, usually institutional investors. The advantages of private placements are lower flotation costs and greater speed, since the shares issued are not subject to SEC registration.

c. A venture capitalist is the manager of a venture capital fund. The fund raises most of its capital from institutional investors and invests in start-up companies in exchange for equity. The venture capitalist gets a seat on the companies’ boards of directors. Before an IPO, the senior management team and the investment banker make presentations to potential investors. They make presentations in tent to twenty cities, with three to five presentations per day, over a two week period. The spread is the difference between the price at which an underwriter sells the stock in an IPO and the proceeds that the underwriter passes on to the issuing firm. In other words, it is the fee collected by the underwriter, and it usually is seven percent of the offering price.

d. The Securities and Exchange Commission (SEC) is a government agency which regulates the sales of new securities and the operations of securities exchanges. The SEC, along with other government agencies and self-regulation, helps ensure stable markets, sound brokerage firms, and the absence of stock manipulation. Registration of securities is required of companies by the SEC before the securities can be offered to the public. The registration statement is used to summarize various financial and legal information about the company. Frequently, companies will file a master registration statement and then update it with a short-form statement just before an offering. This procedure is termed shelf registration because companies put new securities “on the shelf” and then later sell them when the market is right. Blue sky laws are laws that prevent the sale of securities that have little or no asset backing. The margin is the percentage of a stock’s price that an investor has borrowed in order to purchase the stock. The SEC sets margin requirements, which is the maximum percentage of debt that can be used to purchase a stock. The SEC also controls


trading by corporate insiders, who are the officers, directors, and major stockholders of the firm.

e. A prospectus summarizes information about a new security issue and the issuing company. A “red herring,” or preliminary prospectus, may be distributed to potential buyers prior to approval of the registration statement by the SEC. After the registration has become effective, the securities, accompanied by the prospectus, may be offered for sale.

f. The National Association of Securities Dealers (NASD) is an industry group primarily concerned with the operation of the over-the-counter (OTC) market.

g. A best efforts arrangement versus an underwritten sale refers to two methods of selling new stock issues. In a best efforts sale, the investment banker is only committed to making every effort to sell the stock at the offering price. In this case, the issuing firm bears the risk that the new issue will not be fully subscribed. If the issue is underwritten, the investment banker agrees to buy the entire issue at a set price, and then resells the stock at the offering price. Thus, the risk of selling the issue rests with the investment banker.

h. Refunding occurs when a company issues debt at current low rates and uses the proceeds to repurchase one of its existing high coupon rate debt issues. Often these are callable issues, which means the company can purchase the debt at a lower-than-market price. Project financings are arrangements used to finance mainly large capital projects such as energy explorations, oil tankers, refineries, utility power plants, and so on. Usually, one or more firms (sponsors) will provide the equity capital required by the project, while the rest of the project’s capital is supplied by lenders and lessors. The most important aspect of project financing is that the lenders and lessors do not have recourse against the sponsors; they must be repaid from the project’s cash flows and the equity cushion provided by the sponsors. Securitization is the process whereby financial instruments that were previously thinly traded are converted to a form that creates greater liquidity. Securitization also applies to the situation where specific assets are pledged as collateral for securities, and hence asset-backed securities are created. One example of the former is junk bonds; an example of the latter is mortgage-backed securities. Maturity matching refers to matching the maturities of debt used to finance assets with the lives of the assets themselves. The debt would be amortized such that the outstanding amount declined as the asset lost value due to depreciation.

18-2 No. The role of the investment banker is more important if the stock demand curve has a steep slope and the negative signaling effect is substantial. Under such conditions, the investment banker will have a harder time holding up the stock price.


18-3 No. The real value of a security is determined by the equilibrium forces of an efficient market. Assuming that the information provided on newly issued securities is accurate, the market will establish the value of a security regardless of the opinions rendered by the SEC, or, for that matter, opinions offered by any advisory service or analyst.

18-4 a. Going public would tend to make attracting capital easier and to decrease flotation costs.

b. The increasing institutionalization of the “buy side” of the stock and bond markets should increase a firm’s ability to attract capital and should reduce flotation costs.

c. Financial conglomerates can offer a variety of financial services and types of investments, thus it seems a company’s ability to attract capital would increase and flotation costs would decrease.

d. Elimination of the preemptive right would likely not affect a large company where percentage ownership is not as important. Indeed, the trend today seems to be for companies to eliminate the preemptive right.

f. The introduction of shelf registration tended to speed up SEC review time and lower the costs of floating each new issue. Thus, the company’s ability to attract new capital was increased.

18-5 Investment bankers must investigate the firms whose securities they sell, simply because, if an issue is overvalued and suffers marked price declines after the issue, the banker will find it increasingly difficult to dispose of the new issue. In other words, reputation is highly important in the investment banking industry.


SOLUTIONS TO END-OF-CHAPTER PROBLEMS

18-1 a. $5 per shareGross proceeds = (3,000,000)($5) = $15,000,000.Net profit = $15,000,000 - $14,000,000 - $300,000 = $700,000.

b. $6 per shareGross proceeds = (3,000,000)($6) = $18,000,000.Net profit = $18,000,000 - $14,000,000 - $300,000 = $3,700,000.

c. $4 per shareGross proceeds = (3,000,000)($4) = $12,000,000.Net profit = $12,000,000 - $14,000,000 - $300,000 = -$2,300,000.

18-2 Net proceeds per share = $22(1 - 0.05) = $20.90.Number of shares to be sold = ($20,000,000 + 150,000)/$20.90 = 964,115 shares.

18-3 a. If 100 shares are outstanding, then we have the following for Edelman:

2001 2006 Earnings per share $8,160 $12,000Dividends per share 4,200 6,000Book value per share 90,000

b. Using the following two equations, the growth rate for EPS and DPS can be determined.

(1 + gEPS)5 EPS01 = EPS06.(1 + gDPS)5 DPS01 = DPS06.

gEPS gDPS

Kennedy 8.4% 8.4%Strasburg 6.4 6.4Edelman 8.0 7.4

c. Based on the figures in Part a, it is obvious that Edelman’s stock would not sell in the range of $25 to $100 per share. The small number of shares outstanding has greatly inflated EPS, DPS, and book value per share. Should Edelman attempt to sell its stock based on the EPS and DPS above, it would have difficulty finding investors at the economically justified price.


d. Edelman’s management would probably be wise to split the stock so that EPS, DPS, and book value were closer to those of Kennedy and Strasburg. This would bring the price of the stock into a more reasonable range.

e. A 4,000-for-1 split would result in 400,000 shares outstanding. If Edelman has 400,000 shares outstanding, then we would have the following:

2001 2006 Earnings per share $2.04 $ 3.00Dividends per share 1.05 1.50Book value per share 22.50

f. ROE Kennedy 15.00%Strasburg 13.64Edelman 13.33

g. Payout Ratio 2001 2006Kennedy 50% 50%Strasburg 50 50Edelman 51 50

All three companies seem to be following similar dividend policies, paying out about 50 percent of their earnings.

h. D/A is 43 percent for Kennedy, 37 percent for Strasburg, and 55 percent for Edelman. This suggests that Edelman is more risky, hence should sell at relatively low multiples.

i. P/E Kennedy $36/$4.50 = 8.00Strasburg $65/$7.50 = 8.67

These ratios are not consistent with g and ROE; based on gs and ROEs, Kennedy should have the higher P/E. Probably size, listing status, and debt ratios are offsetting g and ROE.

j. The market prices of Kennedy and Strasburg yield the following multiples:

Multiple of Multiple of Multiple of Book EPS, 2006 DPS, 2006 Value per Share, 2006Kennedy 8.00 16.00 1.20Strasburg 8.67 17.33 1.18


Applying these multiples to the data in Part e, we obtain the following market prices:

Indicated Market Price for Edelman Stock Based on Data of: Kennedy StrasburgBased on earnings, 2005 $24.00 $26.01Based on dividends, 2005 24.00 26.00Based on book value per share 27.00 26.55

k. = + g.

Kennedy = + 8.4% = 15.18.

Strasburg = + 6.4% = 12.54%.

Edelman = .

Based on Kennedy: = = $21.54.

Based on Strasburg: = = $33.66.

l. The potential range, based on these data, is between $21.54 and $33.66 a share. The data suggest that the price would be set toward the low end of the range: (1) Edelman has a high debt ratio, (2) Edelman is relatively small, and (3) Edelman is new and will not be traded on an exchange. The actual price would be based on negotiations between the underwriter and Edelman; we cannot say what the exact price would be, but the price would probably be set below $21.54, with $20 being a reasonable guess.

18-4 a. Since the call premium is 11 percent, the total premium is 0.11($40,000,000) = $4,400,000. However, this is a tax deductible expense, so the relevant after-tax cost is $4,400,000(1 - T) = $4,400,000(0.60) = $2,640,000.

b. The dollar flotation cost on the new issue is 0.04($40,000,000) = $1,600,000. This cost is not immediately tax deductible, and hence the after-tax cost is also $1,600,000. (Note that the flotation cost can be amortized and expensed over the life of the issue. The value of this tax savings will be calculated in Part e.)


c. The flotation costs on the old issue were 0.06($40,000,000) = $2,400,000. These costs were deferred and are being amortized over the 25-year life of the issue, and hence $2,400,000/25 = $96,000 are being expensed each year, or $48,000 each 6 months. Since the bonds were issued 5 years ago, (5/25)($2,400,000) = $480,000 of the flotation costs have already been expensed, and (20/25)($2,400,000) = $1,920,000 remain unexpensed.

If the issue is refunded, the unexpensed portion of the flotation costs can be immediately expensed, and this would result in a tax savings of T($1,920,000) = 0.40($1,920,000) = $768,000.

d. The net after-tax cash outlay is $3,472,000, as shown below:

Old issue call premium $2,640,000 New issue flotation cost 1,600,000 Tax savings on old issue flotation costs (768,000) Net cash outlay $3,472,000

e. The new issue flotation costs of $1,600,000 would be amortized over the 20-year life of the issue. Thus, $1,600,000/20 = $80,000 would be expensed each year, or $40,000 each 6 months. The tax savings from this tax deduction is (0.40)$40,000 = $16,000 per semiannual period.

By refunding the old issue and immediately expensing the remaining old issue flotation costs, the firm forgoes the opportunity to continue to expense the old flotation costs over time. Specifically, $2,400,000/25 = $96,000 each year, or $48,000 semiannually. The value of each $48,000 deduction forgone is 0.40($48,000) = $19,200.

f. The interest on the old issue is 0.11($40,000,000) = $4,400,000 annually, or $2,200,000 semiannually. Since interest payments are tax deductible, the after-tax semiannual amount is 0.6($2,200,000) = $1,320,000.

The new issue carries an 8 percent coupon rate. Therefore, the annual interest would be 0.08($40,000,000) = $3,200,000, or $1,600,000 semiannually. The after-tax cost is thus 0.6($1,600,000) = $960,000. Thus, the after-tax net interest savings if refunding takes place would be $1,320,000 ─ $960,000 = $360,000 semiannually.


g. The net amortization tax effects are ─$3,200 per year for 20 years, while the net interest savings are $360,000 per year for 20 years. Thus, the net semiannual cash flow is $356,800, as shown below.

Semiannual Flotation Cost Tax Effects:

Semiannual tax savings on new flotation: $16,000Tax benefits lost on old flotation: (19,200)Net amortization tax effects ($ 3,200)

Semiannual Interest Savings Due To Refunding:

Semiannual interest on old bond: $1,320,000Semiannual interest on new bond: (960,000)Net interest savings $ 360,000Semiannual cash flow: $ 356,800

The cash flows are based on contractual obligations, and hence have about the same amount of risk as the firm's debt. Further, the cash flows are already net of taxes. Thus, the appropriate interest rate is GST's after-tax cost of debt. (The source of the cash to fund the net investment outlay also influences the discount rate, but most firms use debt to finance this outlay, and, in this case, the discount rate should be the after-tax cost of debt.) Finally, since we are valuing future flows, the appropriate debt cost is today's cost, or the cost of the new issue, and not the cost of debt floated 5 years ago. Thus, the appropriate discount rate is 0.6(8%) = 4.8% annually, or 2.4 percent per semiannual period.

At this discount rate, the present value of the semiannual net cash flows is $9,109,425:

PV = $356,800(PVIFA2.4%,40) = $9,109,425.

Alternatively, using a financial calculator, input N = 40, I = 2.4, PMT = -356800, FV = 0, PV = ? PV = $9,109,413.

h. The bond refunding would require a $3,472,000 net cash outlay, but it would produce $9,109,413 in net savings on a present value basis. Thus, the NPV of refunding is $5,637,413:

PV of net benefits $9,109,413Cost (3,472,000)Refunding NPV $5,637,413

The decision to refund now rather than wait till later is much more difficult than finding the NPV of refunding now. If interest rates were expected to fall, and hence GST would be able to issue debt in the future below today's 8 percent


rate, then it might pay to wait. However, interest rate movements are very difficult, if not impossible, to forecast, and hence most financial managers would probably take the "bird-in-the-hand" and refund now with such a large NPV. Note, though, that if the NPV had been quite small, say $1,000, management would have undoubtedly waited, hoping that interest rates would fall further, and the cost of waiting ($1,000) would not have been high enough to worry about.

18-5 a. Investment outlay required to refund the issue:

Call premium on old issue: $5,400,000 New flotation cost: 5,000,000 Tax savings on old flotation: (1,666,667) Additional interest on old issue: 450,000 Interest earned on investment: (225,000)Total investment outlay: $8,958,333

Annual Flotation Cost Tax Effects:

Annual tax savings on new flotation: $ 80,000 Tax benefits lost on old flotation: (66,667)Amortization tax effects $ 13,333

Annual Interest Savings Due to Refunding:

Annual interest on old bond: $5,400,000 Annual interest on new bond: (4,500,000)Net interest savings $ 900,000

Annual cash flows: $ 913,333

NPV of refunding decision: $2,717,128

Using a financial calculator, enter the cash flows into the cash flow register, I = 6, NPV = ? NPV = $2,717,128.

b. The company should consider what interest rates might be next year. If there is a high probability that rates will drop below the current rate, it may be more advantageous to refund later versus now. If there is a high probability that rates will increase, the firm should act now to refund the old issue. Also, the company should consider how much ill will is created with investors if the issue is called. If Tarpon is highly dependent on a small group of investors, it would want to avoid future difficulty in obtaining financing. However, bond issues are callable after a certain time and investors expect them to be called if rates drop considerably.


SOLUTION TO SPREADSHEET PROBLEM

18-6 The detailed solution for the problem is available both on the instructor’s resource CD-ROM (in the file Solution for IFM9 Ch 18 P6 Build a Model.xls) and on the instructor’s side of the web site, http://now.swlearning.com.


MINI CASE

Note to Instructors:Some instructors choose to assign the Mini Case as homework. Therefore, the

PowerPoint slides for the mini case, IFM9 Ch 18 Show.ppt, and the accompanying Excel file, IFM9 Ch 18 Mini Case.xls, are not included for the students on ThomsonNow. However, many instructors, including us, want students to have copies of class notes. Therefore, we make the PowerPoint slides and Excel worksheets available to our students by posting them to our password-protected Web site. We encourage you to do the same if you would like for your students to have these files.

Randy’s, a family-owned restaurant chain operating in Alabama, has grown to the point where expansion throughout the entire southeast is feasible. The proposed expansion would require the firm to raise about $15 million in new capital. Because Randy’s currently has a debt ratio of 50 percent, and also because the family members already have all their personal wealth invested in the company, the family would like to sell common stock to the public to raise the $15 million. However, the family does want to retain voting control. You have been asked to brief the family members on the issues involved by answering the following questions:

a. What agencies regulate securities markets?

Answer: The main agency that regulates the securities market is the Securities And Exchange Commission. Some of the responsibilities of the SEC include: regulation of all national stock exchanges--companies whose securities are listed on an exchange must file annual reports with the SEC; prohibiting manipulation by pools or wash sales; controls over trading by corporate insiders; and control over the proxy statement and how it is used to solicit votes.

The Federal Reserve Board controls flow of credit into security transactions through margin requirements. States also have some control over the issuance of new securities within their boundaries. The securities industry itself realizes the importance of stable markets, therefore, the various exchanges work closely with the sec to police transactions and to maintain the integrity and credibility of the system.

Mini Case: 18 - 15

b. How are start-up firms usually financed?

Answer: The first financing comes from the founders. The first external financing comes from angels, who are wealthy individuals. The next external financing comes from a venture capital fund. The fund raises capital from institutional investors, usually around $70 to $80 million. The managers of the fund are called venture capitalists. The fund invests in ten to twelve companies, and the venture capitalist sits on their boards.

c. Differentiate between a private placement and a public offering.

Answer: In a private placement stock is sold directly to one or a small group of investors rather than being distributed to the public at large. A private placement has the advantage of lower flotation costs; however, since the stock would be bought by a small number of outsiders, it would not be actively traded, and a liquid market would not exist. Further, since it would not have gone through the SEC registration process, the holders would be unable to sell it except to a restricted set of “sophisticated” investors. Further, it might be difficult to find investors willing to invest large sums in the company and yet be minority stockholders. Thus, many of the advantages listed above would not be obtained. For these reasons, a public placement makes more sense in Randy’s situation.

d. Why would a company consider going public? What are some advantages and disadvantages?

Answer: A firm is said to be “going public” when it sells stock to the public for the first time. A company’s first stock offering to the public is called an “initial public offering (IPO).” Thus, Randy’s will go public if it goes through with its planned IPO. There are several advantages and disadvantages to going public:

Advantages to going public:

Going public will allow the family members to diversify their assets and reduce the riskiness of their personal portfolios.

It will increase the liquidity of the firm’s stock, allowing the family stockholders to sell some stock if they need to raise cash.

It will make it easier for the firm to raise funds. The firm would have a difficult time trying to sell stock privately to an investor who was not a family member. Outside investors would be more willing to purchase the stock of a publicly held corporation which must file financial reports with the sec.

Going public will establish a value for the firm.

Mini Case: 18 - 16

Disadvantages to going public:

The firm will have to file financial reports with the SEC and perhaps with state officials. There is a cost involved in preparing these reports.

The firm will have to disclose operating data to the public. Many small firms do not like having to do this, because such information is available to competitors. Also, some of the firm’s officers, directors, and major stockholders will have to disclose their stock holdings, making it easy for others to estimate their net worth.

Managers of publicly-owned corporations have a more difficult time engaging in deals which benefit them personally, such as paying themselves high salaries, hiring family members, and enjoying not-strictly-necessary, but tax-deductible, fringe benefits.

If the company is very small, its stock may not be traded actively and the market price may not reflect the stock’s true value.

The advantages of public ownership would be recognized by key employees, who would most likely be granted stock options, which would certainly be more valuable if the stock were publicly traded.

e. What are the steps of an initial public offering?

Answer: Select an investment banker, file the S-1 registration document with the SEC, choose a price range for the preliminary, or “red herring,” prospectus, go on a roadshow, set final price on final prospectus.

f. What criteria are important in choosing an investment banker?

Answer: (1) reputation and experience in the industry. (2) existing mix of institutional and retail (i.e., individual) clients. (3) support in the post-IPO secondary market, especially the reputation of the analyst who will cover the stock.

Mini Case: 18 - 17

g. Would companies going public use a negotiated deal or a competitive bid?

Answer: The firm would almost certainly use a negotiated deal. The competitive bid process for setting investment bankers’ fees is feasible only for large, well-established firms on large issues, and even here the use of bids is rare for equity issues. This is because the process of making a bid is costly (mainly for the research necessary to establish the price, but also because of the need for sec registration), and investment bankers simply would not incur these costs unless they were assured of getting the deal or the issue was so large that a huge fee awaited the winner.

h. Would the sale be on an underwritten or best efforts basis?

Answer: Most stock offerings are done on an underwritten basis, but the price is not set until the investment banker has checked investors for interest in the stock, and has received oral assurances of commitments at a price that will virtually guarantee the success of the offering barring a major stock market collapse. So, there is little effective difference between a best efforts and an underwritten deal.

i. Without actually doing any calculations, describe how the preliminary offering range for the price of an IPO would be determined?

Answer: Since the firm is going public for the first time, there is no established price for its stock. The firm and its investment banker would project future earnings and free cash flows. The banker would then compare the firm with other restaurant firms of similar size. The banker would try to determine a price range for the firm’s stock by applying the price/earnings ratios, price/dividends ratios, and price/book value ratios of similar firms to the firm’s earnings, dividends, and book value data. The banker would also determine the price at which the firm’s stock would have to sell to earn the same rate of return as other firms in its industry. On the basis of all these factors, the investment bankers would determine a ballpark price. They would then specify a range (i.e., $10 to $12) in the preliminary prospectus.

Mini Case: 18 - 18

j. What is a roadshow? What is bookbuilding?

Answer: The senior management team, the investment banker, and the lawyer make presentations to potential institutional investors. They usually visit ten to twenty cities, and make three to five presentations in each city. Management can’t say anything that is not in the registration statement, because the SEC imposes a “quiet period” from the time it makes the registration effective until 25 days after the stock begins trading. The purpose is to prevent select investors from getting information that is not available to other investors.

During the roadshow, the investment bankers asks the investors to indicate how many shares they plan on buying. The banker records this in his book. The banker hopes for oversubscription. Based on demand, the banker sets the final offer price on the evening before the stock is issued.

k. Describe the typical first-day returns of an IPO and the long-term returns to IPO investors.

Answer: First-day returns average 14.1%, with many stocks having much higher returns. The investment banker has an incentive to set a low price, both to make its brokerage customers happy and to make it easy to sell the issue, whereas the firm would like to set as high a price as possible. Returns over the two-year period following the IPO are generally lower than for comparable firms, indicating that the offering price is too low, but that the first-day run-up is too high.

l. What are the direct and indirect costs of an IPO?

Answer: The underwriter usually charges a 7% fee, based on the offer price. In addition, there are direct costs to lawyers, accountants, printers, etc. That can easily total $400,000.

Indirect costs include the money left on the table, which is equal to the difference between the offer price and end-of-first-day price, multiplied by the number of shares. Also, much of management’s time and attention is consumed by the IPO in the months preceding the IPO.

m. What are equity carve-outs?

Answer: Equity carve-outs are a special type of IPO in which a public company creates a new public company from one of its subsidiaries by issuing public stock in the subsidiary. The parent usually retains a controlling interest.

Mini Case: 18 - 19

n. In what other ways are investment banks involved in issuing securities?

Answer: Investment bankers help companies with shelf registration (SEC rule 451) in which securities are registered but not all of the issue is sold at once. Instead, the company sells a percentage of the issue each time it needs to raise capital.

Investment bankers also help place private and public debt issues. They also help in seasoned equity offers, in which a public firms issues additional shares of stock.

o. What is meant by going private? What are some advantages and disadvantages?

Answer: Going private is the reverse of going public. Typically, the managers of a firm team up with a small group of outside investors, who furnish most of the equity capital, and purchase all of the publicly held shares of the company. The new equity holders usually use a large amount of debt financing, up to 90 percent, to complete the purchase. Such a transaction is called a “leveraged buyout (LBO).”

Going private gives the managers greater incentives and more flexibility in running the company. It also removes the burden of sec filings, stockholder relations, annual reports, analyst meetings, and so on. The major disadvantage of going private is that it limits significantly the availability of new capital. Since the stock is not publicly traded, a new stock issue would not be practical, and, since such firms are normally leveraged to the hilt, it is tough to find additional debt financing. For this reason, it is common for firms that have recently gone private to sell off some assets to quickly reduce the debt burden to more conventional levels to give added financial flexibility.

After several years of operating the business as a private firm, the owners typically go public again. At this time, the firm is presumably operating at its peak, and it will command top dollar compared to when it went private. In this way, the equity investors of the private firm are able to recover their investment and, hopefully, make a tidy profit. So far LBOs have, on average, been extremely profitable--since the 1970s, when LBO firms such as Kohlberg Kravis Roberts (KKR) began operating, their annual rates of return are reported to have averaged over 50 percent annually. However, Wall Street is becoming increasingly concerned about the use of debt, and in the beginning of the nineties the number of new LBOs has fallen dramatically and some old ones have had major financial difficulties.

Mini Case: 18 - 20

p. How do companies manage the maturity structure of their debt?

Answer: In discussing this question, we emphasize that, if markets are truly efficient and conditions are stable, the type of debt instrument will be immaterial, as the cost of each will be commensurate with its risk. However, if markets are not totally efficient (perhaps because management has information which investors do not have), if the company’s tax position changes, if some new security innovation is developed, or the like, then some types of securities might truly be less expensive, on a risk-adjusted basis, than others.

Factors that influence the decision to issue long-term bonds rather than short-term debt:

Maturity matching (assets to be financed)

Information asymmetries. If managers know that the firm has strong prospects, they will issue short-term debt and refinance later when the market recognizes their prospects.

q. Under what conditions would a firm exercise a bond’s call provision?

Answer: Refunding decisions involve two separate questions: (1) is it profitable to call an outstanding issue in the current period and replace it with a new issue; and (2) if refunding is currently profitable, would the value of the firm be increased even more if the refunding were postponed to a later date? If these two conditions are true, a company would exercise their bond’s call provision.

r. Explain how firms manage the risk structure of their debt with: (1) project financing, and (2) securitization.

Answer: 1. Project financings are arrangements used to finance mainly large capital projects such as energy explorations, oil tankers, refineries, utility power plants, and so on. Usually, one or more firms (sponsors) will provide the equity capital required by the project, while the rest of the project’s capital is supplied by lenders and lessors. The most important aspect of project financing is that the lenders and lessors do not have recourse against the sponsors; they must be repaid from the project’s cash flows and the equity cushion provided by the sponsors.

2. Securitization is the process whereby financial instruments that were previously thinly traded are converted to a form that creates greater liquidity. Securitization also applies to the situation where specific assets are pledged as collateral for securities, and hence asset-backed securities are created. One example of the former is junk bonds; an example of the latter is mortgage-backed securities.

Mini Case: 18 - 21

Documents

IFM9 Ch 18 Instructors Manual